How is this for an unbelievable statistic: The number of market indexes now exceeds the number of U.S. stocks! The surge is attributable to the development of new indexes that use custom criteria. This is a huge departure from the traditional indexes (think S&P 500) that are primarily capitalization weighted and easy to replicate by a provider seeking a low-cost way to deliver market-like returns.

The reason for this growth can be attributed to the fee pressure on active management, due to the rise of passive investing over the last eight years. That’s why active managers have been creating specialized mandates that provide new twists on managing to an index (think low volatility or high dividend), typically referred to as fundamental indexing, or smart beta. Let’s not kid ourselves; these mandates are active, but they result in an attractive cost that falls between full active (stock selection) and full passive strategies.

I think this begs the question: If custom indexes are being made to accommodate custom investment strategies, how important is benchmarking in today’s world? I mean, benchmarking has always been a difficult task, left to those who are able to distinguish why an investment strategy may deviate from a benchmark and truly assess a strategy’s performance with that information in hand. When it comes to the client, the benchmark should always, always be their personal objective for the money invested (retirement, sending kids to college or buying that vacation home).

The lure of the S&P 500

When clients are left to their own devices, thanks to the market pundits, they will compare anything and everything to the S&P 500, as if that’s a good gauge to how successful their strategy has been at meeting its objective. That benchmark is a poor comparative for so many reasons. Let’s start with the most obvious ones:

It is a 100% equity benchmark, which provides equity-like returns and equity-like risk. No fixed income for that rainy day downside protection

It only comprises 500 stocks, in a universe of over 4,000

It’s 100% large cap – no small cap, international or emerging markets

And now for some insight gleaned from my own recent calculations that might not be so obvious:

10% of the index is comprised of four companies

11 companies represent 20% of the index

50 companies make up 50% of the index (which means that the other 450 stocks make up the bottom 50%!)

3 of the top 4 names are in information technology (IT)

5 of the top 10 names are in IT

Nearly 25% of the index is invested in IT

It all boils down to the S&P 500 being a poorly diversified, highly concentrated index. On any given day, IT and the top-10 names will drive the index’s performance. Pair that with the capitalization weighted methodology that leads to a pooling effect into the largest names leading to a momentum strategy into stocks that may not even have a track record of producing earnings!

When you actively get passive questions

Advisors have told me that many of their clients are questioning them about passive and driving them toward it – and yet clients, for the most part, really have no idea what it means to invest passively. When I ask advisors how they respond to their investors in these situations, they tell me they either:

Explain the value that active management brings to the table, discuss the downfalls of passive investing and talk about the cyclicality of passive and active, while explaining that we are in the longest period in history of passive outperforming active. Many believe the tide is about to turn and many of the catalysts for that change are playing out.

Use an active investment strategy, such as tactical asset allocation or tax management, implemented with passive investments, such as ETFs. They add value by choosing the most appropriate ETFs by asset class and providing the client with a robust, diversified asset allocation.

Aren’t sure how to respond. They see the argument from both sides and are torn on the subject, which makes it harder for them to provide clients with definitive direction on the right way to invest.

The cold hard truth is both passive and active investment methodologies have their strengths and weaknesses – and, in the end, both should do an adequate job of getting investors where they need to go. That’s because whether investing actively or passively (or a combination of both), it isn’t usually the investment methodology that drives the success of the investor, it is:

The asset allocation of the strategy (key diversification)

The ability of the advisor to help the client remain invested during difficult market situations

The value an advisor adds to the client’s life through comprehensive planning.

For these reasons, you should always bring them back to the heart of matter – personal objectives should be king in any financial conversations with clients (and indices be damned, if need be).

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